By Al Root

This year has been the revenge of the real, with companies making physical goods far outpacing shares of AI-disruptible service and software providers.

Investors might feel pretty good about their industrial stocks right now, but there are still risks.

"Industrials are off to a monster start in 2026," wrote Trivariate Research founder Adam Parker in a recent report. He has a point. Coming into Tuesday trading, Caterpillar and GE Vernova shares were up 22% and 35%, respectively, year to date. The State Street Industrial Select Sector SPDR exchange-traded fund was up almost 6% year to date, about 26 percentage points ahead of the State Street SPDR S&P Software & Services ETF.

There are a few reasons for the outperformance that go beyond rotating out of stocks tied to AI disruption. For starters, expectations of lower interest rates are a help. A lot of industrial equipment is expensive and financed. What's more, the Institute for Supply Management Purchasing Managers' Index, or ISM PMI, recently turned positive after a brutal three-year manufacturing recession. Higher activity is a positive, but Parker warns there is little historical correlation between the ISM and stock prices.

That doesn't mean improvement isn't real. The ISM tends to tell investors what they already know from listening to corporate earnings calls and reading Wall Street research.

The problem now is valuation. GE Vernova stock trades for about 54 times expected earnings over the coming 12 months, up from about 40 times a year ago, according to FactSet. Cat stock trades for about 30 times, up from 16 times.

"Industrials have never been more expensive on price-to-earnings, enterprise value-to-sales, and free cash flow yield," says Parker.

High valuations bring high expectations. "The penalty for missing estimates is even harsher in Industrials than the broader market," he adds. "So it is imperative for the sector to post upwards earnings revisions for the recent outperformance to continue."

There will be no more "stock up after an earnings miss headlines" for the sector in 2026. Results need to be strong.

Three stocks he likes are aerospace parts maker Howmet Aerospace, electrical infrastructure builder Quanta Services, and vehicle maker Federal Signal. Three he wants to avoid are Deere, UPS, and air conditioning distributor Watsco.

Parker is basing that on recent earnings growth and the direction of earnings estimate revisions.

Seaport portfolio strategist Patrick Palfrey added in a Tuesday report that some of the jumps in defense contractors are "unjustified." That could mean investors look to take profits in Northrop Grumman and L3Harris Technologies.

He's comparing changes in stock prices and in each company's earnings outlook.

Shares of air conditioning company Carrier Global and electrical component maker Hubbell have also seen "unjustified" gains. On the other hand, aerospace parts maker Heico has had an unjustified decline in value. Coming into Tuesday trading, shares were down 14% year to date. So have shares of plumbing distributor Ferguson, which were down about 1% year to date.

To be sure, stocks can move in advance of estimate revisions. And the outlook for many industrial subsectors remains strong, including aerospace, defense, and power generation. BofA Securities recently noted that Cat's power generation backlog stretches out to 2029.

Still, reviewing valuations, earnings growth, and estimate changes can help avoid nasty surprises when hot stocks report earnings in the coming weeks.

Write to Al Root at allen.root@dowjones.com

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March 25, 2026 03:00 ET (07:00 GMT)

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